Fran O'Sullivan: Fiscal drag a real downer

Enjoy your tax cuts - you will probably pay for much of them through fiscal drag.

That's the reality for many higher income earners as Finance Minister Michael Cullen "all but" admitted to me on Friday.

Over the past eight years, he has pocketed close to an extra $2 billion in fiscal drag, based on figures provided to me by his office.

This year it will probably be about another $250-$260 million, which will go a good way towards funding the shift in the top tax threshold from $60,000 to $70,000.

As Treasury is under strict orders not to comment on this, or even do the numbers, there's an element of guess work on my behalf.

But the Finance Minister suggested those earning more than $80,000 (8 per cent) would basically fund their cut through the fiscal drag effect.

Cullen's "admission" came after the Wellington Regional Chamber of Commerce's post-Budget luncheon. He noted the top tax threshold was now cutting in at such a low level, it was even catching nurses and teachers - not his original intention.

The Budget increases the level at which the 39-cent rate cuts in from $60,000 to $70,000 on October 1, and then raises it to $80,000 in April 2011 (after another intermediary step).

When he introduced the 39-cent top tax rate in 2000 for those earning more than $60,000, Cullen was fulfilling Labour's 1999 election pledge to make the top 5 per cent pay more.

But, eight years later, it's not the top 5 per cent of tax-paying Kiwis who fall into Labour's "rich" category by earning more than $60,000. That figure is now 15 per cent - the natural upshot of wage and salary increases.

The top 5 per cent in fact earns more than $100,000 these days.

Cullen has no intention of raising the 39-cent threshold to that level.

But there is clearly room for an incoming National Government to reassess the impact on New Zealand's competitiveness by lifting the top thresholds at a faster rate than Cullen's programme.

With 55 per cent of the total income tax of $26,373m paid by those earning more than $60,000, and 29 per cent by those earning $100,000 plus, calls are likely to increase for more cuts at higher income levels over time.

Cullen has faced a lot of flak from banking economists for delivering a profligate Budget. But the reality is that while lower-to-middle income earners receive the greatest tax relief in percentage terms from the tax-cutting programme, the relief offered to higher earners is not so generous. Unless they also benefit from Working for Families tax credits, their relative after-tax incomes - particularly in comparison with Australia - will continue to worsen.

This fact has been glossed over in the post-Budget controversy over whether the so-called generosity of Cullen's tax cuts (a controversy manufactured in the main by banking sector economists) will persuade Reserve Bank Governor Alan Bollard against embarking on interest-rate cuts this year.

Cullen's not about to embark on a power play with Bollard ahead of the election. The Finance Minister is far too cunning for that.

What Cullen is trying to do is persuade financial markets to look through the stimulatory impact of the October 1 tax cuts and focus on the fact they are unlikely to fully compensate New Zealanders for rising costs such as food, petrol and rents.

Even when the Working for Families adjustment is added, the pressure on disposable incomes for lower-to middle-income families will still be substantial.

Treasury is under strict orders to refer any questions on the impact of fiscal drag on expected tax revenues to Cullen's office. Even though its officials could produce a raft of projections on how many taxpayers would earn more than $60,000 over the next four years (nearly 20 per cent by 2012), they have not squared the circle by forecasting how much will continue to come in through fiscal drag on the back of wage and salary increases.

This is an absurdity. Cullen's office defines fiscal drag as the amount of additional growth in personal income tax over and above that which can be adequately accounted for by growth in nominal aggregate wages and salaries.

"This definition of fiscal drag captures the additional revenue as a result of taxpayers facing higher average tax rates. These higher average tax rates result from the interaction between the progressive nature of the personal income tax scale and higher wages, where higher wages includes two components: (i) wages keeping up with inflation, and (ii) wage increases over and above inflation, ie real wage growth."

The Working for Families payments mean many lower-to-middle income families have already been effectively compensated for the impact of fiscal drag on their post-tax incomes. But, until Treasury is allowed to make forecasts, it will be difficult to work out to what extent Cullen has emptied the tills to fund the tax cuts, or how much is left (via fiscal drag) for the next Government to play with.